For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.

Today we’re expanding our investigation into ETF urban legends. No, it’s not true that there are spider eggs in your exchange-traded fund, but let’s look at two more urban legends that touch on taxes and trading.

ETFs are tax-free

A shared characteristic of mutual funds and ETFs is that, instead of paying taxes on gains, they distribute these capital gains directly to investors. Funds of any kind can generate capital gains when they sell a security that has appreciated in price, whether it’s shares of Apple (AAPL) or a 10-year Treasury note.

But before we continue, I need to congratulate you if your fund had a gain. That means securities in your fund have gone up in value, which is a desired outcome! To fund client redemptions, a mutual fund manager may have to sell shares of stocks, possibly at a gain.

However, ETFs are unique because institutions can exchange ETF shares for individual securities in an “in kind” transaction. In this type of swap, no shares are sold and no taxable event happens (no free lunch though: The gain is eventually recognized when the investor sells the ETF). This is one of the sources of the ETF’s tax advantages.

The other? The index tracker approach that most ETFs follow. Because index trackers, whether ETF or mutual fund, attempt to mimic the holdings of their target benchmark, they generally only sell a security from the portfolio if the security exits the target index (for instance, a stock that’s removed from the S&P 500 because it’s no longer large enough). That longer-term or lower-turnover approach is an advantage for ETFs and index funds because it generally produces fewer capital gains distributions. In contrast, a traditional active fund will sell securities more frequently because a stock may have reached a “target” price or because an investment thesis has changed, yielding more capital gains distributions.

ETFs tempt investors to trade more

Is ETFs’ convenience—that they can be bought and sold like an ordinary stock—actually a detractor of value, tempting ETF investors to trade more, resulting in transaction costs and poor results because of their market timing behavior?

A few years ago Vanguard sought to answer this question by examining the trading behaviors of Vanguard retail investors. The study encompassed 3.2 million transactions between 2007 and 2011 in four of Vanguard’s largest ETFs and their related mutual fund share classes.

The results? 62% of ETF investors in the study exhibited “buy and hold” characteristics, as shown in the table. While this was less than the 83% of mutual fund holders, the result appears contrary to the urban legend of a “temptation effect.” Additionally, the study found that some of the difference can be attributed to the fact that investors who are inclined to trade choose ETFs and not that investors who choose ETFs are induced to trade.

Hopefully, we’ve shed some light on the effects of investing in ETFs while simultaneously eating pop rocks…no one’s stomach is going to explode as a result. Although that would make a more interesting front page story, wouldn’t it?

Notes:

Vanguard ETF Shares are not redeemable with the issuing Fund other than invery large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

All investing is subject to risk, including the loss of the money you invest.

Rich Powers

Rich Powers is the Head of ETF Product Management in Vanguard Portfolio Review Department. He joined Vanguard in 1999 and joined Portfolio Review in 2003.

For the majority of his tenure in Portfolio Review, Mr. Powers was a senior member of the Oversight and Manager Search team, which is responsible for identifying subadvisory partners for Vanguard’s active fund lineup and monitoring the firm, people, process, portfolio, and performance of all existing Vanguard funds on behalf of the firm’s senior leadership team and board of directors.

In 2015, Mr. Powers assumed his current role. His team is responsible for conducting surveillance of competitor products and positioning, meeting with clients and prospects to discuss Vanguard's ETF lineup, publishing on noteworthy developments in the ETF marketplace and Vanguard lineup, and supporting ETF education initiatives.

Mr. Powers earned a B.S.B.A. in finance from Shippensburg University and an M.B.A. in investment management from Drexel University.

Comments

Tim Q. | June 14, 2016 2:03 pm

Rich,

If ETFs tracking indexes don’t turn assets over, how is it that SPY is the world’s most actively traded equity by factors, and responsible for roughly 48% of all options volume?

Answer: Arbitrage. People need to understand that a great deal of the volume in both ETFs — virtually all of it — and by extension underlying stocks comprising indexes ETFs track, and associated futures and options, is driven by arbitrage. What that means is that instead of reflecting fundamental factors, prices most of the time in the market reflect the short-term pursuit of profits created by minute separations in baskets of instruments. This is responsible for over 50% of equity market volume (and by extension volume in other securities markets).

In any market, arbitrage should never exceed 15% of total product movement. if it does, the market is not efficient (yet ETFs are predicated on arbitrage). Calling it efficient doesn’t remove the risk that arbitrage depends only on prices. That means a sudden move in, say, currencies can evaporate prices, leaving real investors with no liquidity and no price-support. This is true at all times for ETFs and most times now for all stocks.

To see it, one must read the rules governing setting the NBBO and the fee schedules of the exchanges, and understand the role of APs. We’ve done all that. After a decade of study, this is our conclusion.

True R. | June 14, 2016 3:35 pm

Gene V. | June 14, 2016 1:53 pm

Thanks for the article, Rich. I was a bit surprised to hear you say that a 21% drop in Buy-and-Hold behavior on a sample of 3.2 million transactions led you to support a null hypothesis (i.e. “contrary to…temptation effect”). Of course the next comment that “some of the difference can be attributed” to another effect is relevant in supporting that hypothesis, but without being quantitative, the attribution to temptation effect or not remains unsupported.

Regardless of the attribution for the 21% difference, is it true that the reduced Buy-and-Hold behavior does NOT detract from ETF valuation? You actually admit to there being a difference in practices, so I haven’t found the question answered.

Carl S. | June 14, 2016 11:15 pm

Hi Carl,
For a Vanguard investor with access to free trades on Vanguard ETFs and low-cost Admiral™ Shares, there’s very little difference at all—they’re both excellent ways to get access to low-cost index strategies. If you value being able to trade throughout the day, then maybe the ETF looks a little better. ETF trades take a few days to settle, as opposed to mutual fund trades, which settle the next day, so if you have an unexpected cash need, then maybe the Admiral Share class is for you.

Carl S. | June 16, 2016 5:52 pm

My question was rhetorical. I agree that the difference between an ETF and a low cost mutual fund investing in the same index is usually insignificant for anybody who does not do frequent trading — as most investors shouldn’t.

Although it is not quite an index fund, I use one of Vanguard’s short term bond funds as a back-up to a bank checking account, and find it convenient to be able to occasionally write checks on that fund to make large payments. So in that respect it is more suitable for me than an equivalent ETF, and over time, the dividend payments (originating as interest payments) approximately compensate for inflation.

However, in deciding how to allocate my investments between mutual funds and ETFs, I evaluate them on their own merits and consider statistics on what other investors are doing to be academic. It’s OK to mention these statistics, which are probably of use to Vanguard in designing its marketing to prospective customers, but I don’t think that they have any practical value to established customers like me.

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For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.